CorpFin Class 1- Capital Budgeting

8/6/2019 CorpFin Class 1- Capital Budgeting

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1) Online Smart Class

22nd May,2011Time: 6 pm to 7 pm IST(please go to the link to attend the class

http://connectpro49277231.adobeconnect.com/corpfin1-dec/ )Link and Instructions will also be availableon www.FinBricks.com on 21st May 2011

2) Class @ Mumbai, India

22nd May,2011 from 11 am to 1 pm IST

LocationFinbricks classes, Pearl centre,near sadguru classes, 2nd floor,Krishna jejurkar,Dadar (W) 400028(5 mins walk from Dadar Station)


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Copyright @ FinBricks

[email protected]


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Projects identification and Evaluation

Cash Flows (CF) more than a year

Decisions that impact future earnings Examples- Replacement, innovation,

expansion

Impact other decisions such as Workingcapital, Strategic actions

Projects that increase shareholder value

2Copyright @ FinBricks


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Idea generation

Analysis of the proposal- Forecasting of

cash flows

Make firm-wide decisions

Monitor and post audit to see if actual

performance is meeting forecasts

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Copyright @ FinBricks4


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Replacement Projects

Replacement for cost Reduction

Expansion Projects New Products/Market

Mandatory Projects- Government and

Insurance related OtherProjects- Corporate Perks, High risk

Projects, R&D



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Independent & Mutually Exclusive(ME) Independent-Can select multiple independent

projects at the same time

M E- Need to prioritize. You can have only 1

Project Sequencing Project planning. Invest in one today will lead to

another opportunity tomorrow

Fund allocations Unlimited- Take all projects with returns greater

than Required return

Limited- Capital rationing. Projects that providemax value to shareholders



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Make decisions based on CASH FLOWS

Incremental cash flows

After-tax Cash Flows Externalities (impact on existing project cash

flows by taking up this new project)

Negative Cannibalization to be taken into

accountx Positive



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Opportunity Cost Loss incurred as other opportunities/projects are

forgone to take up the project under

consideration Time Value of Money

Cash flow received earlier are worth more thanthose received later ( certainty, discounting,inflation effect)

Cash Flow Patterns Conventional cash flows

Non-conventional cash flows



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Accounting Income

Sunk costs

Costs that are incurred whether you take the

project or not. (feasibility study, Consulting fees,start-up marketing).

Financing costs Reflected in Required rate of return (RoR)x RoR is the minimum return required to take up the

project. This is further adjusted to reflect project riskx It is the firms cost of capital/ discount ratex Only projects that provide a higher return than RoR

should be accepted



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NPV

IRR

Payback Period

Discounted PaybackPeriod

Profitability Index



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Net Present Value (NPV) Sum of PV of INCREMENTAL AFTER-TAX cash

flows

PV

Future cash flows discounted back to showwhat is their value as of today

Discount rates

x Use FIRMs cost of capital /RoR adjusted forrisk level for discounting future incrementalafter-tax cash flows



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NPV of Normal Project


(-Initial Cash Flow) + CF1+ CF2+ CF3..CFn

(1+k) (1+k)(1+k)(1+k)1 2 3 n

K=Required rate of return for project(RoR may be higher or lower than firms cost of capital to reflectproject risk)


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A B

Initial Inv 2000 2000

Year 1 1000 200

Year 2 800 600

Year 3 600 800

Year 4 200 1200

Cost of capital 10% 12%


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For Independent projects

Accept if NPV is positive

Reject if NPV is negative



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Trail & Error (Guessing game)

Use the Financial Calculator

Decision Rule based on the project RoR

If IRR>ROR then accept

If IRR< ROR then reject



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A B

Initial Inv 2000 2000

Year 1 1000 200

Year 2 800 600

Year 3 600 800

Year 4 200 1200

Cost of capital 10% 12%


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Project A Project B

Initial Inv equal equal

Total Cash Inflows lower higher

Timing of Cash flows earlier later


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Crossover Rate

Cost of Capital

NPV $

5 10 15 20

Project Bs NPV

Project As NPV

Project Bs IRR

Project As IRR


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Discount Rate NPV A NPV B

0% 500 700

5% 350 370

10% 130 90


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NPV & IRR give same accept/reject decisions forindependent projects. Example if A has positive NPV than it will also have an IRR

which is higher than the cost of capital

IRR and NPV can provide different rankings whileselecting Mutually exclusive projects. Example A has higher NPV than B but B has higher IRR than

A

Difference in the projects ranking for IRR and NPV isbecause of Timing of Cash flows- NPV reinvests CFs at Cost of capital,

IRR reinvests CFs at the internal rate of return Project Size- Small investments will have higher IRR but will

not increase the absolute value of the firm as much as aproject with high investments providing higher NPV

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Remember that both give same

accept/reject decisions

Incase of Mutually Exclusive project, NPVand IRR may provide different ranking

Base your decision on NPV as it measures

the expected increase in wealth fromundertaking a project which in turn

directly impacts the firm value



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Non conventional CF When cash flow pattern is non-normal then there

could be No IRR or Multiple IRR

However NPV also works for non conventionalCFs

Reinvestment rate IRR assumes the reinvestment rate of

incremental project CFs at the internal rate ofreturn which is quite unrealistic. It should bereinvested at the cost of capital. NPV takes careof this issue

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You make an investment in new machineforUSD 500 mn and expect CF of 750 mn

Your enterprise is currently worthU

SD50/share with shares outstanding of 100 mnwhich makes your firm value=5 billion

NPV of new project= 750-500=250 mn

Value of company after project=5bn+250mn=5.25bn

New share price= 5.25 bn/100 mn shares=52.5/share



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PaybackPeriod

Breakeven period for investment

In how many years will I recover myinvestment

Drawback- Liquidity measure not profitabilityDoes not consider TVM

Used with NPV and IRR by firms

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Investment 1000

Year 1 cash inflow- 200

Year 2 cash inflow- 400 Year 3 cash inflow- 300


Cumulative CFs

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Cumulative Cashflows

Year 1 cash inflow -800

Year 2 cash inflow -400 Year 3 cash inflow -100

Year 4 cash inflow +200

Payback period= 3 yrs +100/300

= unrecovered cost/netcash flow in the last yr


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Considers Time Value

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Investment 1000

Year 1 cash inflow- 200 Year 2 cash inflow- 400



Cumulative CFs

Cumulative Cashflows(Assumed to be

Discounted at 10%) Year 1 cash inflow -800

Year 2 cash inflow -400 Year 3 cash inflow -100

Year 4 cash inflow +200

Payback period= 3 yrs +100/300

= unrecovered cost/netcash flow in the last yr


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Same as NPV but gives a ratio and not

the absolute value of the project

Greater than 1 accept, less than 1 reject

PI= PV of future CF/ CF0

= 1 + (NPV

/CF0)

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Location Specific Europe uses payback more than or as much as

NPV, IRR

Size Larger companies use DCF techniques like IRR,

NPV

Public vs Private Public cos prefer DCF techniques, Private usePayback

Management Education Higher level of mgmt education, the more the

use of DCF techniques

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Documents

CorpFin Class 1- Capital Budgeting